issues in financial reporting

Issues in Financial Reporting

Corporate Financial Reporting

Notes taken from Preface and Issues in Financial Reporting in Corporate Financial Reporting by Andrew Higson,

published Sage 2005

Headings

Overall Theory of accounting Motivations of management External auditing Driving forces behind developments in

financial reporting Conceptual framework (accounting theory)

OverallBusiness environment is dynamic.

The driving forces are:

- globalisation- extreme market pressures- advances in technology- knowledge economy- fraud- influence of management

Overall

Other driving forces are:

- perspective on information in F.Ss- debate about financial performance- corporate governance- independence- ‘real time’ reporting- audit developments- assurance services

Overall

. . . leading to a revolution in accounting data:

- in the need for . . .

-> financial reporting

- (and) in the way it is usedd

Theory of accounting - The conceptual issues behind financial reporting.- There is no one generally agreed theory of

accounting. - The underlying accounting theory is vague and

ill-defined.- the objective of financial statements has been

specified vaguely (see below).- Conceptual frameworks have been devised (MP).- (but), to achieve consensus, there has been - compromises by the accounting standard setting

bodies.

Theory of accounting

The focus is on the myriad of accounting users:- The standard setting bodies have gone for ‘decision-usefulness’ of financial statements (to ‘users’).- Auditors do not support this.- Company Law Review and Caparo judgemet (in law) also rejects thisShould be focussing on:- the reporting entity- communication of its performance and riskQuestion is:- How to judge an entity’s performance and risk?


There may be an accounting (financial reporting) expectations gap, comprising:

- an audit expectations gap

- an financial statements expectations gap


- There has been conceptual framework projects undertaken by the accounting standard setting bodies

- Are these conceptual frameworks really conceptual?

- Is one generally agreed theory of accounting at all possible?

Motivations of management

We need to understand

- the motivations of management and - the work of the external auditors

to understand financial reporting.

Therefore, to understand figures in financial statements,

it is important to understand management’s motivations.

The external audit needs to be seen in terms of

an audit of management’s motivations.


The final figures in the financial statements may be

- the result of negotiations between management andtheir auditors.

Auditors therefore should examine

- the reasonableness of management’s justification for their arguments.


Focus (instead) by standard setters on accounting users:

The standard setting bodies have gone for - ‘decision-usefulness’ of financial statements

(to ‘users’).

- Auditors do not support this.

- Company Law Review and Caparo judgemet (in law) also rejects this.


Should be focussing on:- the reporting entity- communication of its performance and risk

Question is:- How to judge an entity’s performance and risk?

- May be an accounting (financial reporting) expectations gap, comprising:

- audit expectations gap- financial statements expectations gap

External auditing

Financial Reporting and external auditing are inextricably linked,

- as shown by recent financial scandals.

Inter-relationship between external auditing

- and the provision of assurance

- to those outside the reporting entity

External auditing

‘Effective reporting and accounting,

and external scrutiny (i.e., auditing) . . .,

are essential for effective corporate governance

(Company Law Review Steering Committee, 2001, para. 8.1)

External auditing

In order to understand - the work, problems and opinion

of the external auditors,

we need to appreciate - the scope and limitations of financial statements.

And, in order to understand the financial statements,we need to appreciate - the scope and limitations of

the work, problems and opinion of the external auditors.

External auditing

External audit needs to be seen in terms of audit of - management’s motivations.

The final figures in the financial statements may be - the result of negotiations between management

and their auditors.

Auditors therefore would examine:- the reasonableness of management’s justification for their arguments.

Therefore, to understand the figures in the financial statements, - it is important to understand management’s motivations.

External auditing

- Auditing and financial reporting encompass a multitude of judgements and assumptions.

- Auditing is as much about understanding (the) accounting data in (its) context.

External auditing

The focus is on the myriad of accounting users:- The standard setting bodies have gone for ‘decision-usefulness’ of financial statements (to ‘users’).- Auditors do not support this.- Company Law Review and Caparo judgemet

(in law) also rejects thisShould be focussing on:- the reporting entity- communication of its performance and riskQuestion is:- How to judge an entity’s performance and risk?

External auditing

Question is:

How to judge an entity’s performance and risk?

May be an accounting (financial reporting) expectations gap, comprising:

- audit expectations gap

- financial statements expectations gap

Driving forces behind financial reporting developments:

- Globalisation- influence of management- extreme market pressures- advances in technology- knowledge economy has developed:- fraud- independence

Driving forces behind financial reporting developments:

- perspective on information in financial statements (F.Ss.)- debate about financial performance- corporate governance- audit developments- assurance services- ‘real time’ reporting

globalisation

- a push for international (harmonisation of) accounting standards

- debate over whose standards to adopt.

- From 2005, listed EU companies now have to use international accounting standards

- (of the International Accounting Standards Board, or IASB)

- IASB was previously IASC (see other [older] lecture notes)

globalisation

- recognition of the politicisation of the accounting standards setting process.

(Armstrong, 1977; Solomons, 1978; Zeff, 2000)

- (recognition of?) the implications of economic consequences of accounting standards and policies

(Zeff, 1978)

- (need to look at) the political context of adoption of international accounting standards

- as well as the accounting context

- the setting of international accounting standardsis now ‘in crisis’!

(Horton and Macve, 2000, 26)

globalisation

- today’s complex economic world requires a break from the auditing traditions that have evolved

from the early balance sheet audit (Bell et al, 1997, 12).

- Especially the emphasis on the business risk approach to auditing.

(Lemon et al, 2000)

globalisation

- Industrial age companies ran on tangible assets such as stock, machinery, etc.

(Elliott, quoted by KPMG, 1999, 18)

- Post-industrial age companies run on intangible assets

- such as information, human resources and R & D. (Elliott, quoted by KPMG, 1999, 18)

- We must understand these new ingredients for value creation and destruction


influence of management

Management is central to any discussion of financial reporting: - whether at the level of laws (Parliament) or of- regulations (accounting standards setting bodies) or of- official accounting bodies’ pronouncements.

(Moonitz, 1974, 64)

Lack of support from the preparers of financial statements - for changing the basis of valuation in accounting

(from historic cost to current cost)

- However, current cost is beginning to creep into financial statements

influence of management

However, others (e.g., corporate executives)

- accuse the accounting standard setting bodies of having a ‘hidden agenda’

- to undermine historical cost - by bringing in piecemeal current cost

(Miller and Loftus, 2000, 5)

Concern that accounting standard setting bodies - are requiring data that management

does/will not find useful for its own internal use

extreme market pressures

Concern that pressure from capital markets is - forcing managements to achieve (ever higher)

earnings targets.

- Danger of aggressive earnings management, - resulting in shareholders and the capital market

being misled about an entity’s performance and profitability

(APB, 2001, 3).

Recent financial scandals can be seen as being - a result of extreme disclosure

and earnings management.

perspective on information in financial statements (F.Ss.)

Emphasis is now on providing information - so that users of F.Ss. can take decisions and - make assessments of the future cash flows of entities.- users have been actively involved in dialogue

about accounting principles- users are represented on some accounting standard setting bodies.

But: should accounting knowledge be: - articulated by non-acountants? - Should the patient tell the doctor . . .?

(Hines, R.D. (1989)


Focus on accounting users:- Concentration on ‘decision-usefulness’ of financial statements (to ‘users’). - Auditors do not support this.- Company Law Review and Caparo judgemet (in law) also rejects this.- May lead to unrealistic views about/of what accounting can provide


- Concentration on future? - Or on the past?

- Can’t be both?

- Government, shareholders, employees want - the past - (profits)!

- Bank(er)s want the future (cash flows)!

- But - Bank(er)s don’t need financial statements ! - They have company’s budgets, etc.

- Key shareholders increasingly meet privately with managements

(Holland, 1997; Marston, 1999)


- Anyway, are shareholders all that rational? (Scott, 1994, 62)

- Are stock exchanges all that efficient? (Scott, 1994, 62)

- If not, this threatens the basis on which financial accounting- Calls for a “return to fundamentals”.Should be focussing on:- the reporting entity- communication of its performance and riskQuestion is:- How to judge entity’s performance and risk?

debate about financial performance

- financial statements include a statement of total recognised gains & loss

- but users seem to be ignoring this statement (ASB, 2000)

Should be focussing on:- the reporting entity- communication of its performance and risk

Question is:- How to judge an entity’s performance and risk?

debate about financial performance

- Is a question of what is meant by performance.

- Whether just focusing on ‘financial performance’ will really indicate an entity’s overall

performance- In management accounting,

limitations of financial performance have resulted in a search for other, complimentary indicators, `such as the balanced scorecard

(Kaplan and Norton, 1996).

advances in technology

Questioning the relevance of financial statements.- decision makers, such as potential investors,

creditors, customers and suppliers have asked for (demanded):more timely and broader information

(CICA, 1999, 2)

- decision makers’ information needs will be met at least in part by:- real time access to corporate databases

(CICA, 1999, 2)


Accounting is the instrument used to treat a mass of enterprise facts so that the flow of transactions becomes intelligible

(Littleton, 1953, 25)A contribution to understanding is made by compressing a mass of facts and setting up the resulting data in ways that permit comparisons to be made

(Littleton, 1953, 25).


Figures lose most of their significance unless the eyes can see quickly whether they are larger or smaller than they were

(Littleton, 1953, 25).Double-entry book-keeping’s relevance has been questioned

(Doost, 2000)BUT some sort of accounting system will still be neededAlso, real time reporting could be the ultimate in short-termism

knowledge economy has developed:

- there is an emphasis on tangible assets in financial reporting- but is a concern that the financial statements may not

reflect this development- information and knowledge are replacing capital and

energy as the primary wealth-creating assets (Enterprise Development Website, 2000, 1)


- technological developments have transformed - the majority of wealth-creating work - from physically-based to ‘knowledge-based’.

(Enterprise Development Website, 2000, 1)- Technology and knowledge are now - the key factors of production.

(Enterprise Development Website, 2000, 1)


- We are now an information society in a knowledge economy.

(Enterprise Development Website, 2000, 1)- Under 30% of market capitalisation is represented by book value.

(Lindsey, 2001, 117)- Over 70% of value is falling outside the public

measurement and reporting system. - This a dramatic shift (reverse) from 20 years ago.

(Lindsey, 2001, 117)

corporate governance

- accountability has long been seen as one of the reasons for financial reporting.- the importance of corporate governance has risen in recent years- Company Law Review (2001) which said:- corporate governance is central to - future developments in corporate reporting - and accountability

corporate governance

- Need to view accounting in light (context) of corporate governance and not other way around

- And corporate governance encompasses much more than financial reporting.

- In the midst of this, auditors have had to respond and to react to criticisms of their work!

(Short et al, 1999)

independence

- the key quality of the external audit.- auditors have frequently been criticised for

a perceived lack of independence.- If auditors are not independent,

the relevance of the audit can be questioned.

audit developments

- there has been a perceived change - in the emphasis in the audit:- from ‘audit efficiency’ to ‘audit effectiveness’.- one aims to reduce costs, - the other is concerned with - whether the audit is achieving its objective.

assurance services

- the pressure to add value to the external audit - has resulted in a consideration of - how to extend the audit function.- opportunities for assurance services to expand to - the new types of information used by decision makers:

(Elliott, quoted by KPMG, 1999, 18)- i.e., independent professional services that improve - the quality of information, or its context, - for decision makers


‘real time’ reporting- real time database approach to external reporting- has major implications for external auditors- the information provided on a real time basis - to investors will inevitably raise question of - its reliability

(Panel on Audit Effectiveness, 2000, 172)- the perceived need for more timely assurance - has given rise to the notion of continuous assurance -through a continuous audit. (CICA, 1999)- users of the financial statements want continuous assurance about the systems and controls within anorganisation.

fraud

accounting history is littered with examples of financial information used as a means of deception

(Edwards, 1989, 143)fraudulent financial statements are of great concern not only to the corporate world, but also to the accounting profession. Every year the public has witnessed spectacular business failures reported by the media

(Vanasco, 1998, 60)

fraud

These catastrophic events have shocked the public, undermined auditors’ credibility in their reporting function, and eroded public confidence in the accounting and auditing profession.

(Vanasco, 1998, 60)Detection of fraud is often cited as a chief expectation of external auditors.Auditors are now expected to plan their audit to have a reasonable expectation of detecting material misrepresentations arising from error or fraud

(APB, 1995, para. 18).

Conceptual framework (accounting theory)

It is critical there is a firm conceptual basis underpinning financial reporting to tackle these issues.

A careful study of the foundations upon which accounting has been constructed needs to undertaken

(Ijiri, 1967, ix)There are numerous challenges from neighbouring areas to accounting

(Ijiri, 1967, ix)


Accounting has its own way of thinking about, observing, and organising business phenomena

(Ijiri, 1967, ix).Accounting has its own philosophy and discipline, which have developed over centuries

(Ijiri, 1967, ix).

One way of tackling the multitude of problems facing financial reporting is to build on accounting theory.


Accounting theory and practice are inseparably connected, neither can stand alone

(Littleton, 1953, 1).To understand practice fully, we have to understand theory

(Littleton, 1953, 1)To understand theory (its integrated structure) fully, we have to understand something of the totality of accounting practice and of its related fields

(Littleton, 1953, 1).


The changing nature of accounting has implications for development of theory.What impact will all the developments have on accounting theory?Practice will change over time.Will (should) theory change?How far anyway can accounting change and still be called accounting?


Accounting theory discussion is usually about financial accounting and financial reportingBut is ill-defined, with broad scope and is political.Should we think in terms of accounting theory?Decision-usefulness has been the cornerstone of conceptual (theoretical) developments since the 1960s.Agency theory and communication theory may be better conceptual bases from which to view financial reporting (according to Higson, 2005)


- One of the major problems (esp. in the Anglo-Saxon business world) is that most users are divorced from the running of the business

- so they may not have the appropriate level of knowledge to assess their management’s stewardship of their assets.

Powerpoint presentation by M C Pratt, St Martin’s College, UK.

Content of slides have been taken directly or have been revised and/or amended from:

• Corporate Financial Reporting by Andrew Higson published by Sage, 2005

• Most points above are notes (which are virtually quotes) taken directly from the above text or have been taken and then amended and/or revised by M C Pratt.

• There are additional points made by M C Pratt.

Acknowledgement...

issues in financial reporting

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